Low REIT Yields Point to Below Average Returns

Real Estate Investment Trusts have outperformed the S&P 500 by nearly 30% in the last year. This has pushed an already low dividend yield even lower to 4.36%, a level below the yield of any other time except for a few weeks in April of this year, and a nine month period at the peak of the real estate bubble. Coming so soon after a bubble, this is slightly surprising. Valuations after a bubble tend to stay low for a while as the memory of the bubble is still fresh in investors minds.

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With the dividend yield this far from normal, future real returns will probably be low. The primary source of returns from REITs is dividends, so a low yield is a strong indicator that returns will be below average. Unlike stocks, there has been pretty much no growth in fundamental value of REITs in the past. Because they must pay out most of their earnings as dividends, most REITs don’t grow without raising capital. This is reflected in the past dividend growth of the FTSE NAREIT index, which has not changed much from zero over the full business cycle.

In addition to a low return from dividends, it is also possible that we will see a drop in prices if investors demand higher yields. For the dividend yield of REITs to return to its historical average, REIT prices would have to drop 47%. However, with interest rates at extremely low levels, it may be that the dividend yield of REITs will remain low while the Federal Reserve keeps interest rates down. If this is the case, than valuing REITs relative to treasuries should be insightful. When this is done via the yield spread, REITs no longer appear overvalued.

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The yield spread, currently at 1.67%, is higher than the historical average of about 0.9%. The key here, though, is that this is relative to treasuries. If treasuries have very poor returns, than a slightly higher return is still likely to be unsatisfactory.

Disclosure: No positions in REITs

Small Cap Stocks Appear Overvalued

Small cap stocks have had a strong run since the bear market bottom in 2009, outperforming large cap stocks by a big margin.

Outperformance of this magnitude begs a question. Are small cap stocks overvalued relative to large cap stocks?

To answer this question, I searched around for some information on relative valuations and found the following chart at hussmanfunds.com. This chart shows the ratio of the median P/E of the largest 30 stocks in the S&P 500 to the median P/E of the smallest 30 stocks and the subsequent 5 yr relative performance.

Source: hussmanfunds.com

Obviously, the chart is old and can’t be used for current relative valuations, but it is useful for gaining a historical perspective. From looking at the chart, the median ratio appears to be around 1, meaning that on average small cap stocks have had a similar median P/E ratio to large cap stocks.

Currently the median P/E of the largest 30 stocks in the S&P 500 is 14.2, while that of the smallest 30 stocks is 16.1, putting the current Big PE/Small PE ratio at 0.88. If, instead of using the 30 largest and smallest stocks in the S&P 500, the ratio is calculated with the S&P 500 and 600, than the result of 0.875 is essentially the same.

With the ratio at this level, it is probable that large cap stocks will deliver meaningful outperformance. Of course, it is always possible for large cap stocks to become more undervalued relative to small cap stocks, but than they would be an even better investment.

Other Notes:

The S&P is likely to return close to nothing over the next several years. If small caps underperform as is likely, than there is a strong possibility of returns actually being negative.

As we discussed a little over a week ago, the valuation spread is near its historical norm, implying that neither growth nor value stocks will outperform by much in the next few years. Combining that with a tilt towards large cap stocks would mean Large Cap GARP stocks are the place to be right now. Our stock rating system uses a GARP strategy to identify stocks to own and could be a starting place for further research.

Can Expensive Stocks be Cheap Relative to Value Stocks?

In a recent article on Bloomberg, a market strategist at UBS uses the valuation spread of the industries with the highest and lowest P/Es to measure relative value between high P/E (growth) stocks and value stocks. While I disagree with his conclusion that high P/E stocks will outperform value stocks, I think the data shows that the valuation spread has an effect on future relative performance.

A short study by the Brandes Institute has a chart in it with the gap in valuations of growth and value stocks. This was measured by sorting stocks by P/B, then using the ratio of the median P/B in the top decile to the median P/B in the bottom decile. The correlation of this ratio to the future 5 yr returns of value stocks relative to growth stocks appears to be fairly strong.

In Jeremy Grantham’s 1q 2010 letter, he discusses growth versus value and has a chart of the relative valuation of the cheapest 25% of stocks by P/B to the market. Again this method of measuring the valuation spread appears to have a fairly strong correlation to future relative performance of value stocks vs. growth stocks.

While, I don’t have the historical data and can’t find out exactly how high the correlation is between the valuation spread and future relative returns, it certainly seems high enough that a reasonably close guess can be derived from it.

So, what relative performance can we expect from growth stocks vs. value stocks over the next several years? Currently the ratio used to measure the valuation gap in the study by the Brandes Institute is around 11.5, which is slightly above the median of 11.1. The metric in Grantham’s 1q 2010 letter is around 0.48, a little bit below the median. For both metrics to meet their median level, value stocks would have to outperform growth stocks by a small amount.

And back to UBS’s forecast of growth stocks outperforming value stocks, I think there are a few possible reasons  I come to a different conclusion.

• I used P/B, not projected P/Es. The earnings in the denominator are more volatile than book value and the P/E can often be at levels that do not make sense. Also, projected earnings are often very different from actual earnings.
• I used the spread between stocks instead of the spread between industries.

So in conclusion, when the spread between valuations of growth stocks and value stocks has reached an extremely low point, than growth stocks have outperformed value stocks. Thus, even though it may sound counter-intuitive, growth stocks can become cheap relative to value stocks. Although this is possible, it is unlikely that this is currently the case.